WWII 064: The Buffett Indicator Today, Companies Promoting Stock, Exercising Options, Buffett Wins a Big Bet
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Main Topic: The Buffett Indicator - Ratio of the Dow to Gross National Product
On my podcast, I am constantly pointing out that in order to know what price to pay for an investment, one should know how much it is worth. The mathematics behind the valuation of a specific security is relatively simple.
What if a guy wants to know what the overall valuation is in the stock market, and whether or not in falls into one of three categories: over-valued, fairly valued, or under-valued? What metric should we use?
Fortunately for us, Warren Buffett himself has pointed out the metric that he uses to determine whether or not we have reached an abnormal valuation in the stock market. Sometimes referred to as the “Buffett Indicator,” this metric is the ratio of Gross National Product (or “GNP”) to Market Cap.
Let’s start by defining each term and how it’s used.
Gross National Product is an estimate of total value of all the final products and services produced in a given period by the means of production owned by a country's residents.
Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the NASDAQ. The DJIA was invented by Charles Dow back in 1896.
In this article in Forbes dated December 10, 2001, Buffett detailed the relationship between Gross National Product which represents the output of the American Economy (Buffett called it the “business of the country”), and Market Capitalization represented by the Dow Jones Industrial Average.
Ideally, GNP and the Dow will grow at roughly the same rate, as the improvement in GNP should be reflected in growing earnings of the companies that comprise the Dow. So if we create a chart with the ratio of GNP to the Dow over the decades, it should show us this relationship and there should be times when that relationship is way out-of-wack and we can draw some probabilities of future returns.
For example, in times when the increase in market capitalization does not keep pace with the improvement in GNP, there should be some value to be taken in stocks. In times when market cap increase faster than GNP over a period of time, stocks may be due for a correction of some sort.
Here is what Buffett had to say about this relationship when charted:
“For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%--as it did in 1999 and a part of 2000--you are playing with fire. As you can see, the ratio was recently 133%.”
He said this in that 2001 article that was written after the Internet bubble burst. The ratio had approached 200% before the bubble burst. After the burst, in 2001, it was sitting at around 133%. I like to think of the 70-80% range as the “Buffett buy point”.
The GNP to Market Cap ratio has been modified over time in a number of different ways. Many purported Buffett ratios actually use GDP or Gross Domestic Product, instead of Gross National Product. Second, the market cap indicator that is used is not always the Dow.
Gurufocus.com uses GDP divided by the Wilshire Total Market indicator.
This ratio indicator has a recent reading of 129%, compared with the internet bubble of close to 150%. In several charts on the website, you can see GDP clearly growing.
One can interpret the outcome of this ratio in several ways. First, in periods where the market cap has grown at a greater rate than GNP, but not an extreme level, it is possible that market cap stays within a range while GNP catches up.
A second possibility is that GNP stalls and the market cap falls back into line in correction.
In periods where GNP grows at a faster rate than market cap, the market may be considered somewhat undervalued and the market capitalization will eventually rise to reflect the increase in earnings and valuations of individual securities. A second possibility is that the market anticipates a decline in the increase in GNP and GNP falls to meet the pace of the market cap increase.
Regardless, if you just look at two lines on a graph, GDP, and market capitalization, the both continue to increase over time.
We are currently around 125% - 129%, depending on how the ratio is constructed. Certainly well above the Buffett buy point, but still below what would be considered an extreme level.
Ask JB: Can companies hire a public relations firm to promote their stock?
submitted 4 hours ago by Idontg1veafu
JB Says: Some companies do occasionally hire a PR firm to promote the stock. I know this because I have received calls from these firms. Most of the time, if management believes their stock is undervalued, they will signal this by implementing a stock buyback plan, or even by directors or management buying shares personally. Barron’s has a section in it that shows recent insider buying and selling activities. There are many reasons to sell a stock, but only a few to buy. Some new directors are required to buy common shares as part of their employment agreement, and that doesn’t mean that they believe the shares are undervalued. However, a current director buying a large block of shares may signal their belief that the stock is undervalued.
submitted 1 day ago by Boukephalos
JB Says: To exercise an option on Scottrade, you have to call in and tell them that you want to exercise. However, you may make a higher profit if you just sell the option in the open market. You will pay less in fees, and take advantage of the time premium still in the option price.
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